Straddles and Strangles

Steve Meizinger
ISE Education

ISEoptions.com
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Required Reading

For the sake of simplicity, the examples that follow do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of a given strategy. An investor should review transaction costs, margin requirements and tax considerations with a broker and tax advisor before entering into any options strategy. Options involve risk and are not suitable for everyone. Prior to buying or selling an option, a person must receive a copy of CHARACTERISTICS AND RISKS OF STANDARDIZED OPTIONS. Copies have been provided for you today and may be obtained from your broker, one of the exchanges or The Options Clearing Corporation. A prospectus, which discusses the role of The Options Clearing Corporation, is also available, without charge, upon request at 1-888-OPTIONS or www.888options.com. Any strategies discussed, including examples using actual securities price data, are strictly for illustrative and educational purposes and are not to be construed as an endorsement or recommendation to buy or sell securities.

Options have value for two reasons

Cost of money- Interest rates less dividends Volatility- How much the asset varies during the length of the options contract

Black-Scholes option model

Parameters of Black-Scholes model are: Stock price Strike price Time remaining until expiration Risk-free interest rates and dividends Volatility as measured by standard deviation

Volatility defined
Volatility is the amount of movement an underlying can exhibit, either up or down The official mathematical value of volatility is defined as the annualized deviation of stocks daily price changes

Types of Volatility

Historical Volatility- Measure of actual

underlying price changes over a specific period of time

Implied Volatility- measure of how much the

market expects the underlying asset to move, for an option price. This is backward engineered from the Black-Scholes model, solving for volatility instead of theoretical option price

Volatility levels
Volatility generally increases during periods of falling stock prices Volatility generally decreases during periods of rising stock prices There are exceptions though, if a stock rises quickly, volatility may actually rise

Options require a forecast

What if you were to be uncertain on direction but were predicting a large move up or down in an underlying asset? A couple of strategies might benefit from dramatic movements in the market

Straddle
Example- One forecast: XYZ could be much higher or much lower in the future??

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Example

Stock is $22.19 Buy the 47 day 22.5 call for $1.70 and buy 47 day 22.5 put for $1.80, total debit $3.5 Implied volatility is 57%, this is the backward engineered from the trading price that is derived from the option exchanges

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Risk/Reward graph

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Sell straddle to close position prior to expiry

Profitability depends on how far the stock moves and implied volatility

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Straddle position at expiration

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Breakeven at expiration
Straddle buyer purchases two rights, right to buy stock at $22.5 and the right to sell stock at $22.5 Upside breakeven point $22.5 + $3.5= $26.0 Downside breakeven point $22.5 - $3.5= $19

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Straddle cost is $3.50

Stock at expiry
14 16 18 19 20 22.5 24 26 28 30

Call value 22.5

0 0 0 0 0 0 1.5 3.5 5.5 7.5

Put Value 22.5p

8.5 6.5 4.5 4 2.5 .0 0 0 0 0

P&L
5 3 1 0 -1 -3.5 -2.0 0 2 4

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Risk and Reward is balanced

If an investor is predicting a dramatic move up or down this strategy may be suitable Risk and reward are inextricably linked

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Strangle
Another alternative strategy: Buy 47 day 25 strike call for .75 and buy 47 day 17.5 strike put for .50 Investor has the right to sell stock at 17.5 and the right to buy stock at 25 until expiration Strangle volatility purchased was an implied volatility of 58%

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Risk/reward graphs

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Sell prior to expiry

Profitability depends how far stock moves and the implied volatility at the time of sale of the strangle

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Risk/reward at expiry

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Strangle breakeven at expiration

Downside breakeven is $17.5-$1.25= $16.25 Upside breakeven is $25+ $1.25= $26.25

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Volatility is the key to option pricing

One concern: Implied volatility, the market forecast for future volatility is much higher than the historical volatility Economics may be too difficult? What if the volatility reverts back to 40%

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Why does the situation occur?

Market may be expecting news that will dramatically impact the underlying price of the stock, either positively or negatively Examples of this may include FDA rulings, product litigation cases and earnings announcements

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Example
Stock is $22.19 Buy the 47 day 25 call for $.75 and buy 47 day 17.5 put for $.50, total debit is $1.25

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Risk/reward prior to expiry

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Sell strangle to close prior to expiry

Profitability depends on how far the underlying moves and the implied volatility when you exit the option The implied volatility purchased was approximately 58%

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Strangle position at expiration

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Breakeven at expiration
Strangle buyer purchases two rights, right to buy stock at $25 and the right to sell stock at $17.5 Upside breakeven point is $25 + $1.25= 26.25 Downside breakeven point is $17.5 - $1.25= 16.25

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Strangle cost is $1.25

Stock at expiry 14 16 16.25 18 20 22 24 26 26.25 28 30

Call value 25 0 0 0 0 0 0 0 1 1.1 3 5

Put value 17.5 3.5 1.5 1.25 0 0 0 0 0 0 0 0

P&L 2.25 .25 0 -1.25 -1.25 -1.25 -1.25 -.25 0 1.75 3.75

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1 Week later follow-up

Stock increases due to a positive earnings announcement 7% (23.70), volatility drops 28% (43 implied volatility)

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Case study
Stock up 7% Vol down 28% Original Price 1 Week later P&L

Straddle

3.5

3.2

-.30

Strangle

1.25

.90

-.35

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Comparing Straddles and Strangles

Straddles- higher cost, lower leverage, and the breakeven points are closer together Strangles- Lower cost, higher leverage, and the breakevens are further apart

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Risk and Reward is balanced

If an investor is predicting a dramatic move up or down this strategy may be suitable The maximum loss for either straddle or strangle purchase is the debit paid Risk and reward must always be balanced Selecting either a straddle or strangle to benefit from price movement will be determined by weighing the cost of each strategy and the breakeven points

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Summary
Investor must be predicting a large move in an underlying to enter into a long straddle or strangle Volatility can be a major factor for profitability of strangles and straddles, caution must be used as future volatility is difficult to forecast

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